The shape of things to come: US mandatory collateral regime for uncleared swaps

It should not be long until the US regulators finalise the collateral requirements regulation applicable to uncleared swaps. With compliance scheduled to start on 1 December 2015 (a tight schedule indeed, considering the final rules are not out yet), below is an indication of what might be on the cards.

There are two regulatory sources for the margining rules applicable to uncleared swaps:

for those swap entities[1] subject to prudential regulation (typically US banks and foreign banks with branches in the US), the margining rules are dictated by their prudential regulators;[2]

for the rest of swap dealers and major swap participants, the rules are issued by the Commodity Futures Trading Commission (“CFTC”).

Unless otherwise noted, we shall refer here to the prudential regulators and the CFTC collectively as “the regulators”.

The latest instalment of the prudential regulators’ proposed rules was dated 3 September 2014, whilst the CFTC’s version is dated as of 3 October 2014.

This article summarises the requirements in the proposed rules, and some of the most material issues they pose and the most significant concerns voiced by the industry, as evidenced by the comments submitted to the regulators during the comment period, which closed at the end of 2014.

The first set of proposed rules was issued in 2011. The decision was later taken to harmonise the US margining requirements in line with the recommendations by the Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commission (“IOSCO”) of September 2013, setting out the international framework for uncleared swaps’ collateralisation.

In general.

Margining is divided into initial margin and variation margin.

Initial margin consists of security posted or collected at the transaction’s inception, calculated as an estimate of future exposure. If there is a netting set of transactions, initial margin will be calculated taking into account all such transactions.

Variation margin is security posted or collected during the course of a transaction or a netting set of transactions, as the result of actual fluctuations in exposure.

Given that the regulators cannot impose regulatory requirements on entities other than swap entities, the mandate for them is not only to post, but also to collect collateral where prescribed. If a counterparty fails to post collateral to, or accept posted collateral from a swap entity, the swap entity will have discharged its obligation if it has made the necessary efforts to collect or post collateral as required.

Initial margin.

Scope of application.

Under the proposed rules, swap entities will be required to post and collect initial margin for all uncleared swaps:

with other swap entities; and

with financial end users deemed to have a material swaps exposure,

subject to a threshold of USD65m, below which margin is not required to be collected. Such threshold is calculated by taking into account the aggregate exposure of all uncleared swaps between a swap entity and all its affiliates and a counterparty and all its affiliates.

Initial margin also applies to uncleared swaps entered into between a swap entity and its affiliates, provided said affiliates are swap entities or financial end users. This is likely to detract from the benefit of any available inter-affiliate exemption from clearing.

Under the proposed rules, the term financial end user includes:

bank holding companies and their affiliates;

depository institutions, foreign banks;

broker-dealers;

private funds;

registered investment companies;

securitization vehicles;

commodity pools;

commodity pool operators;

commodity trading advisors;

futures commission merchants;

investment advisers;

employee benefit plans;

insurance companies;

cooperatives (if financial institutions);

entities that raise money from investors primarily for the purpose of investing in loans, securities, swaps, funds or other assets for resale or other disposition or otherwise trading in loans, securities, swaps, funds or other assets;

foreign entities that would be financial end users if they were organised in the US;

savings and loan holding companies;

nonbank financial institutions supervised by the Fed;

federal or state credit unions;

state-licensed or registered credit or lending entities;

money services businesses;

real estate investment companies;

securities holding companies;

business development companies;

private mortgage REITs; and

any other entities that the CFTC or the prudential regulators so determine.

A financial end user is deemed to have a material swaps exposure if such entity, taken together with its affiliates, have an average daily aggregate notional amount of uncleared swaps, uncleared security swaps, uncleared FX forwards and uncleared FX swaps in excess of USD3bn, calculated for business days only, for June, July and August of the previous year.

Initial margin is not required for uncleared swaps with non-financial end users.

Acceptable collateral, calculation and segregation.

There are slight differences between the kinds of collateral acceptable for initial margin purposes under the prudential regulators’ proposal and that of the CFTC, but generally include:

cash;

debt securities issued or guaranteed by the US Treasury or another US agency;

certain US-sponsored debt securities;

debt securities issued or guaranteed by the European Central Bank;

debt securities issued or guaranteed by the International Monetary Fund, the Bank for International Settlements or multilateral development banks;

certain debt securities issued by sovereigns;

certain corporate debt securities;

certain listed equity securities; and

gold

For collateral other than cash, the proposed rules apply haircuts of up to 25%.

The minimum transfer amount in the proposed rules is USD650,000.

Swap entities may calculate initial margin, either according to a standard look-up table issued by the regulators, or according to its own internal models, which must follow certain parameters and must have been previously approved by the applicable regulator.

In case there is a netting agreement in place, such as an ISDA Master Agreement, the proposed rules require that calculation of initial margin take into account all swaps under such netting agreement, including those entered into prior to the initial margin compliance date. This means that initial margin would apply retroactively to legacy swaps.

Swap entities must hold all initial margin received in a segregated account with an independent, unaffiliated entity which, in its role as custodian, is prohibited from rehypotecating, repledging or transferring the funds held.

The obligation to segregate all initial margin without exception is at odds with CFTC regulation 23.701 (which swap dealers had to comply with just a few months ago), whereby swap dealers must notify all their counterparties their right to segregate initial margin and require that each counterparty elects whether to segregate initial margin indicating, if applicable, the details of the chosen custodian.

If initial margin segregation is to be mandatory in all cases, expect a major repapering to follow later this year, undoing the previous exercise under CFTC regulation 23.701.

Compliance dates.

The requirements to post and collect initial margin are phased-in in accordance with the below table.

Under the proposed rules, if:

the average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, uncleared FX swaps and uncleared FX forwards, computed for business days only

for each of a swap entity and its respective counterparty, plus their respective affiliates

for the periods below

exceeds the amounts set out below,

the compliance dates shall be as set out below, in each case:

average daily aggregate notional amount over

Compliance date

USD4tn for June, July and August 2015

1 December 2015

USD3tn for June, July and August 2016

1 December 2016

USD2tn for June, July and August 2017

1 December 2017

USD1tn for June, July and August 2018

1 December 2018

Zero

1 December 2019

Variation margin.

Scope of application.

Under the proposed rules, swap entities will be required to post and collect variation margin for all uncleared swaps:

with other swap entities; and

with financial end users,

subject to a threshold of USD65m, below which margin is not required to be collected. Such threshold is calculated by taking into account the aggregate exposure of all uncleared swaps between a swap entity and all its affiliates and a counterparty and all its affiliates.

Variation margin also applies to uncleared swaps entered into between a swap entity and its affiliates, provided said affiliates are swap entities or financial end users.

Acceptable collateral, calculation and segregation.

Only cash denominated in USD or in another currency in which payments have been agreed to be made constitutes acceptable collateral under the proposed rules. This will likely pose a drain on liquidity.

The minimum transfer amount in the proposed rules is USD650,000.

As in the case of initial margin, when there is a netting agreement in place, variation margin would take into account all swaps thereunder, including those entered into prior to the initial margin compliance date.

There is also the requirement of posting and/or collecting variation margin at least daily – something we believe is contradictory with the parameters that trigger collateral collection, namely, that exposure should have increased above the applicable threshold and minimum transfer amount at any time.

Unlike initial margin, variation margin is not required to be segregated, though the parties are free to agree on it if they wish to.

Compliance date.

The obligation to post and collect variation margin is set to start on 1 December 2015.

Cross border considerations.

The cross border approach differs between the prudential regulators and the CFTC.

Prudential regulators’ approach.

The prudential regulators make it clear that their margining rules would not apply to swaps where neither party to an uncleared swap (or a guarantor) is:

a US entity;

a US branch, office, or subsidiary or a non-US entity; or

controlled by a US entity.

The prudential regulators also set out the possibility of making substituted compliance available to non-US swap entities, in case the margining requirements to such entities were subject under their respective home regulation were determined to be comparable to those under the prudential regulators’ rules.

CFTC’s approach.

Conversely, the CFTC has included in their proposed rule an advance notice of proposed rulemaking, requesting comment from the market on the following three alternative approaches:

treating the margining rules as transaction level requirements, consistent with the cross-border guidance;

taking the same approach as the prudential regulators; or

treating the margining rules as entity level requirements.

The scenarios in (a) and (b) are roughly comparable. The one in (c) is a maximum extraterritoriality scenario that, in the absence of full substituted compliance, would likely make compliance difficult for non-US swap entities (especially if the margining requirements issued by their own regulator conflict with the CFTC’s), as well as hinder their competitivity.

Industry’s reaction.

Several trade associations, industry groups and market participants have submitted their comments to the regulators with their feedback to the proposed rules. Their comments highlight the following:

At the time of writing, there is little over ten months remaining until the scheduled 1 December 2015 start date. During that period, swap entities need to gear up for compliance in terms of systems, policies and procedures, controls, documentation (which needs to be previously agreed with their counterparties, as well as agreeing the necessary segregation arrangements), risk parameters and, when applicable, initial margin models.

However, to date, the final rules have yet to be published. That translates into swap entities not knowing exactly what they will need to comply with and, therefore, not knowing how they will need to build up their capabilities. Given those concerns, the regulators have been asked to grant swap entities additional time to comply.

Given that cash is the only acceptable collateral under the proposed variation margin rules (applicable to all but non-financial end users), the industry is concerned that the margining rules might result in a liquidity drain from the financial system. Commenters have argued that the requirements are unworkable and will result in increased systemic risk.

The obligation to apply initial and variation margin to inter-affiliate trades is viewed as likely to offset any benefit that would otherwise result from the inter-affiliate exemption from clearing.

By applying the proposed rules to securitisations, the ability for the vehicle to obtain the credit ratings required for any given issue would likely be compromised.

The lack of co-ordination between the US regulators and their foreign counterparts creates the scope for materially differing margining regulations in different jurisdictions, with the attendant risk of market fragmentation and regulatory arbitrage.

Contact us for a confidential, no-obligation discussion.

[1] I.e., swap dealers, major swap participants, security-based swap dealers and major security-based swap participants. There are currently no entities in the latter two categories as the SEC has not yet finalised the rules applicable to security-based swaps.

[2] The prudential regulators are each of the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Agency.